Calendar Spreads


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Calendar Spreads
Reasons to Put on a Calendar Spread
Calendar Spread as a Directional Play
Back-of-the-envelope calculation for implied move





Calendar Spreads

Calendar spreads, also known as time spreads, are extremely versatile strategies and can be used to take advantage of a number of scenarios while minimizing risk. A calendar spread consists of buying or selling a call or put of one expiration and doing the opposite in a later expiration. More often than not, this involves buying or selling an option in the front month (the expiration closest to the current date) and selling or buying an option of the same strike either the next month or a few months out. They can also be done using weeklies instead, especially around events. Call or put calendar spreads look alike on a graph of profit and loss.

A calendar spread is considered long if you buy the later month option and short if you sell the later month options. Since later month options have more time value and cost more, you will pay for a long calendar spread and receive money for a short time spread. Your maximum loss until the first expiration on a long calendar spread is the cost of the calendar spread. If stock moves too far and the strike is either way in-the-money or way out-of-the-money the time value of the spread will go to zero as the options will be worth the same amount, either parity or zero. Your ideal for a long calendar spread is for the underlying to be exactly at the calendar spread strike at  the first expiration.

Reasons to put on a calendar spread:

In a long calendar spread you are short gamma, positive theta and long vega (see section on greeks). Therefore, you want the stock to stay still and the implied volatility to go up. Does that sound unlikely? It need not necessarily be so, but the calendar spread does require some refined thought about what your expectations are for an underlying.

At-the-money front month options decay the most as expiration approaches. If stock stays still the long calendar spread allows a trader to benefit from that decay (as he or she is short the front month option) without being naked short an option.

Let’s say there is a large horizontal volatility skew between two months. If you think the implied volatility in a front month is outsized to the movement you expect in that month and if you think the implied volatility in a later month is trading low given that there are potential events upcoming, then you might put on a long calendar spread to take advantage of this implied volatility skew. If you are correct than implied volatility will come in on the front month option plus time decay. You can buy it back or wait for it to expire and own the later option at a good price. You could use that later option as the first leg of a spread. (An example from the site in CSCO here.)

With a short calendar spread, you are long gamma, negative theta and short vega. You want stock to move, but implied volatility to come in.  You might want to put on a short time spread if you are in the midst of a very volatile moment for the underlying, but think that it can’t last. In this case you would want to be long gamma, but it is going to be expensive as the implied volatility is high. By selling a time spread, you can take advantage of the near term volatility while minimizing cost and with the expectation that the later month implied volatility, if it is trading higher than historical, has a good probability of coming in.  This is a nice strategy in sketchy market conditions where everything has been jittery.  The gamma of the front month option protects you from near term movement and yet the short vega of the longer term option allows you to sell high premium while allowing time for it to come in.   The danger of a short calendar spread is that after the near term option expires you are left naked short an option. We will talk about taking off calendar spreads below.

Calendar spread as directional play

The calendar spread can also be used as a directional play. On the site we have used the long calendar spread for stocks going into earnings. For example, say the market is implying a move of 5% on earnings.*  If we expect the market is correct, we might choose a direction and put on a call time spread if we are bullish or a put time spread if we are bearish on the strike that is 5% in the direction we think the stock will move. The best case scenario is if the stock moves to that strike and then, since the event has happened, it stays still until expiration. Ideally, if implied volatility was not as elevated in the later month as in the front month then the implied volatility will collapse much more in the front month than in the later month.

In early winter 2012, Dan successfully used a Jan/March long call calendar spread in NFLX and a Feb weekly/March long put calendar spread in AMZN going into their earnings. He used a Feb weekly/March long call calendar in GMCR, but earnings overshot the predicted strike. In this case, you can see how the calendar spread still made money, but not as much. Also note the thought process that went into when to take off the spreads.

Many people have asked about why to use a calendar spread as directional play as opposed to a call or put spread. In general, calendar spreads take advantage of horizontal volatility skews. Some of this can be based on market-wide conditions. For example, with the VIX trading historically high, it’s likely that back months across the board in options will be a bit pumped up as well, therefore a call or put spread might make a better directional play than owning vega which is historically high. On the other hand, if the VIX is low, then in the case of a specific event there might be a nice skew between the event month or week and later months. Owning vega at historically low levels is a lower risk proposition and the high implied volatility in the front option is likely to come in after the specific event in a placid market. In Fall 2011 when the VIX was high Risk Reversal had more call and put spread recommendations on the site, whereas now in early Winter 2012  with the VIX trading low, calendar spreads have had more potential.

VIX graph Sept. 16, 2011 to Feb. 10, 2012 courtesy of  LiveVolPro


Calendar spreads are a bit tricky in that the options don’t expire at the same time so there is often debate about when to take them off. As Dan pointed out in the NFLX calendar spread, after the event whether to keep a long calendar spread on becomes a “theta vs. vega” debate. Will the decay in the front month option beat the collapse in vega of the back month call? This depends on how still the stock stays and how pumped up the later month may have been by the event. There is always the option of keeping the spread on past expiration and being long or short an option. Perhaps with a long call spread you are confident that you have bought the later option at a good price and that implied volatility will go up. You might want to hold on to it or even use it as the first leg of a call or put spread. With a short time spread you are left naked short an option after the first expiration so risk is unlimited unless you leg into a spread.

Other things to keep in mind with calendar spreads are dividends which may happen between the two option expirations and changes in short interest rates. Make sure that your inputs are correct and up-to-date and beware of hard-to-borrow stocks as the possibility of a changing short interest rate and buy-ins can change the value of the options disproportionately.

* Back-of-the envelope calculation for percentage implied move of an event
If the event is taking place near expiration, most often if the underlying has weeklies, then take the price of the at-the-money straddle (call price + put price) and divide by the price of the stock.  This gives you a rough estimate.  For more information on estimating implied event moves not near expiry, please see our post on the subject.

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